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Smart investing means being prepared for economic shocks

by Wayne Cheveldayoff, 2005-09-22

Would your investment portfolio survive an economic shock from a flu pandemic, a U.S. recession or the Canadian dollar soaring to par with the U.S. dollar?

While these are not yet on the horizon and they cannot really be regarded as likely, there is nevertheless a chance they may happen.

Investors who prepare themselves and their portfolios for such scenarios will end up keeping more of their money than those who are unprepared.

This doesnít mean that you necessarily have to immediately restructure your portfolio.

But at least you should think through, perhaps with the help of an investment advisor, how your portfolio would be impacted in each case and then decide in advance what you will do to protect your life savings.

Having an action plan is crucial. You donít want to be dithering or arguing with your investment advisor about the right thing to do when the crisis begins to emerge.

At the first hint of trouble, you want to make your moves quickly to get the best prices. Taking a 10-per-cent loss is always preferable to taking a 20 or 30-per-cent loss, and it is always good to have cash on hand when assets are cheap.

An international flu pandemic would be the most disruptive to the economy. It could mean hundreds of thousands, perhaps millions, of people around the globe losing their lives.

A lot of commerce would come to a halt as quarantines take effect or people simply stay home.

With economic activity disrupted, stock markets would sink as market participants would fear the worst. Nothing would be spared, except perhaps stocks of companies making vaccines. Resource prices would be particularly hard hit as the economy slowed.

But bonds, particularly strip bonds, would do particularly well as interest rates fall, both because major pools of money would be fleeing to the safety of government bonds and central banks would be easing short rates to support the economy.

Keep a close watch on events in Asia where a dangerous bird flu is presently infecting humans. At the first sign of the flu jumping between humans, the right course would be to sell a good chunk, if not all, equities, even if the problem seems confined to Asia and hasnít yet spread anywhere else. In our interconnected world, it inevitably will spread and by the time it reaches North America, the stock market would be a lot lower.

A U.S. recession would similarly hurt stocks and benefit bonds but the effects would probably be more muted.

Several respected economists and portfolio managers have already warned that the U.S. consumer is overburdened with debt and all it would take to trigger a recession would be for the consumer to stop borrowing.

So much money is being borrowed each month through home mortgage re-financings that just a temporary pause in this would cause a major slowdown in consumer spending and trigger a recession.

However, if investors wait for a recession to be confirmed in the GDP statistics, they will likely miss their chance to sell. Historically, the equity market usually discounts a recession well before economists agree that a recession is underway.

A prudent plan would be to draw a line in the sand for your equity portfolio, much like a stop-loss order. You should resolve that if the stock market slips below a certain predetermined level, you would sell stocks, particularly consumer-oriented stocks, and then wait to see what happens.

A Canadian dollar shooting to par may presently seem out of the question. But oil prices reaching $100 a barrel, as some predict, and money flowing into the country to invest in our energy assets could move our dollar sharply higher, especially if the Bank of Canada is at the same time raising interest rates to fight inflation.

In such a scenario, exporters would be hurt the hardest and their stocks should be avoided. They are already having trouble with the Canadian dollar at 85 cents U.S.

A rising dollar is also toxic to some income trusts that depend on cash flowing in from their U.S. operations. Most of these trusts have hedged their foreign exchange exposure, some for as long as five years, but if the dollar is still high when these hedges expire, distributions would likely be cut.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2005 Wayne Cheveldayoff